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Why Donaldson Might Not Be A Buy

This filtration products company has a very strong business model, but this may already be priced in, and then some.

Donaldson(NYSE:DCI) is a manufacturer of filtration systems and their replacement parts. Operations are divided into two segments: Engine Products and Industrial Products. Founded in 1915, the company employs more than 12,000 people. Although the work that Donaldson does isn't all that exciting, the company definitely has a market for their products for years to come. A strong business model is in place, but that might already be priced in.

Business modelDonaldson sells a wide range of products including liquid filters, air filters, exhaust and emission systems, on and off road engines, industrial filtration systems, gas turbine filters, and more. Donaldson clearly has its hands in a number of markets such as aerospace, trucks, construction, agriculture, mining, etc. The chart below illustrates Donaldson's targeted markets. These markets make up an estimated $20 billion out of an estimated $50 billion filtration market (the rest of the market, which Dondalson is not addressing, is represented by the gray area).

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Source: May 2014 Donaldson Investor Presentation

As you can see, Donaldson sells their filtration products to a very diversified customer base. This is a key strength for the company, as it doesn't rely too heavily on revenue from any one area. In fiscal 2013, there was no one customer that accounted for more than 10% of net sales. Furthermore, the company is diversified in a number of ways. Sales are divided between engine and industrial markets, OEM's and replacement part customers, as well as between international and North American customers. In fiscal 2013, Engine Products made up 60.8% of operating income, Industrial Products made up 39.7%, and "Corporate and Unallocated" made up -0.5%. The US made up 26% of operating income, Europe made up 31.6%, 30.3% for Asia-Pacific, and 12.1% for "Other". Despite the fact that Donaldson is profiting from a little bit of everything, the company has a revenue of "only" $2.44 billion for the trailing twelve months. This is out of an estimated $20 billion dollar target market, showing that the company still has plenty of room for improvement.

So who is standing in the way of Donaldson taking even more market share? There are a few major competitors that the company has. Among the competition, there are filtration companies as well as small, filtration-focused portions of larger businesses. Donaldson's major competitors, to name a few, are Cummins(NYSE:CMI), Pall(NYSE:PLL), CLARCOR(NYSE:CLC), and 3M(NYSE:MMM). Pall and CLARCOR focus heavily on filtration products, while 3M and Cummins are multi-billion dollar corporations with heavy involvement in the filtration market. Let's compare the companies:

As you can see, Donaldson doesn't necessarily stand out as being at an advantage, nor a disadvantage. It is toward the lower end for size, about in the middle for profitability, and in good shape when it comes to returns and financial health. Donaldson has carved out a small spot for themselves in this market that they aim to continually grow, slowly but surely. Above all, this has produced free cash flow that has been continually rising over the long term, shown by the chart below:

Valuation After creating a decent niche for themselves in the filtration market, Donaldson has established itself as a successful company. As they continue to diversify across markets and geographic locations, the growth at Donaldson is likely to come at a slow and steady rate. A breakdown of this expected growth was illustrated in a 2014 investor presentation:

This forecasted growth is modest compared to the high teens growth the company has been seeing over the course of the last few years. But this wasn't necessarily unexpected, as it can be extremely difficult to maintain those types of growth rates in any industry. Let's look at the value of shares based on a comparison with peers:

Donaldson is above average in three of these, and clearly doesn't appear to be all that cheap. In two out of those three, though, Donaldson is within one standard deviation of the average. Although it might not be overvalued, the company's stock certainly isn't at much of a discount. With a fair price and a bright future, Donaldson might meet some investors' criteria to pull the trigger, but certainly not everyone's.